QUANTITATIVE ANALYSIS (ISD

551) Dr. Emmanuel Quansah

Lecturer:
Department: Supply Chain and Information Systems - KSB
Office: SF 25, KSB Undergraduate Block
 Module 3:
Decision
Analysis
Module
Outline
1. The Six Steps in Decision Making
2. Types of Decision-Making
Environments
3. Decision Making Under
Uncertainty
4. Decision Making Under
Risk
5. Decision Trees
Introduction
• What is involved in making a good decision?
• Decision theory is an analytic and systematic
approach to the study of decision making
• Decision Analysis can be used to develop an
optimal strategy when a decision maker is
faced with several decision alternatives and
an uncertain or risk – filled pattern of future
events
GOOD
DECISION
A Good Decision is one that is based on the following:

1. Logical analysis

2. Considers all available data

3. Considers all possible alternatives

4. Applies quantitative approach

BAD
DECISION
• A Bad Decision is one which does not consider logical
analysis, available data, possible alternatives and
does not use quantitative methods of decision making.
The Six Steps in Decision
Making
1. Clearly define the problem at hand
2. List the possible alternatives
3. Identify the possible outcomes or states of nature
4. List the payoff (typically profit) of each combination of
alternatives and outcomes
5. Select one of the mathematical decision theory
models
6. Apply the model and make your decision
Thompson Lumber Company (1
of 3)
• Step 1 – Define the problem
• Consider expanding by manufacturing and marketing
a new product – backyard storage sheds
• Step 2 – List alternatives
• Construct a large new plant
• Construct a small new plant
• Do not develop the new product line
• Step 3 – Identify possible outcomes, states of nature
• The market could be favorable or unfavorable
Thompson Lumber Company (2
of 3)
• Step 4 – List the payoffs
• Identify conditional values for the profits for
large plant, small plant, and no development for
the two possible market conditions
• Step 5 – Select the decision model
• Depends on the environment and amount of risk
and uncertainty
• Step 6 – Apply the model to the data
Thompson Lumber Company (3
of 3)
TABLE 3.1 Decision Table with Conditional Values for
Thompson Lumber

STATE OF NATURE
FAVORABL UNFAVORABL
E E MARKET
MARKET
ALTERNATIVE ($) ($)
Construct a large plant 200,000 −180,000
Construct a small plant 100,000 −20,000
Do nothing 0 0

Note: It is important to include all alternatives, including “do

nothing.”
 Types of Decision-Making
Environments
• Decision making under certainty
• The decision maker knows with certainty the consequences of every
alternative or decision choice
• The future state-of-nature is assumed known.

• Decision making under uncertainty

• The decision criteria are based on the decision maker’s attitude toward
life.
• There are several possible outcomes for each alternatives.
• The decision maker does not know the probabilities of the
various outcomes
• Decision making under risk
• There are several possible outcomes for each alternative and
• The decision maker knows the probabilities of the various
outcomes
Elements Of Decision
Analysis
1. Alternative Course of Action
2. States of Nature
3. The Likelihood of the State of Nature
4. The Pay-off
 Decision Making Under
• Uncertainty
Criteria for making decisions under uncertainty

1. Maximax Criterion (optimistic or aggressive

approach)
2. Maximin Criterion (pessimistic or conservative
approach)
3. Criterion of realism (Hurwicz)
4. Equally likely (Laplace)
5. Minimax Regret Criterion (pessimistic or
conservative approach)
Maximax Criterion
(Optimistic)
• Used to find the alternative that maximizes the maximum payoff
– maximax criterion

• Decision Rules:
• Determine the maximum payoff for each alternative
• Select the alternative with the largest value

TABLE 3.2 Thompson’s Maximax Decision

STATE OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM IN
MARKET MARKET A ROW
ALTERNATIVE ($) ($) ($)
Construct a large plant 200,000 −180,000 200,000
Maximax
Construct a small plant 100,000 −20,000 100,000
Do nothing 0 0 0
 15

PAY-OFF TABLE: Profit contribution

($000)
Future sales level
Decision Low Medium High

Manufacture -15 10 55

Buy Abroad 10 30 25
Buy
Domestic 5 20 40
Pessimistic
• Used to find the alternative that maximizes the minimum
payoff – maximin criterion
• Locate the minimum payoff for each alternative
• Select the alternative with the maximum number
TABLE 3.3 Thompson’s Maximin Decision
STATE OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM IN
MARKET MARKET A ROW
ALTERNATIVE ($) ($) ($)
Construct a large plant 200,000 −180,000 −180,000
Construct a small plant 100,000 −20,000 −20,000
Do nothing 0 0 0
Maximin
Criterion of Realism (Hurwicz) (1
of 2)
• Often called weighted average
– Compromise between optimism and pessimism
– Select a coefficient of realism α, with 0 ≤ α ≤ 1
α =1
is perfectly optimistic
α =0
is perfectly pessimistic
– Compute the weighted averages for each
Weighted average = α(best in row)
alternative
– Select the alternative with the+highest
(1−α)(worst
value in row)
Criterion of Realism (Hurwicz) (2
of 2)
For the large plant alternative using α = 0.8 (0.8)
(200,000) + (1−0.8)(−180,000) = 124,000
For the small plant alternative using α = 0.8 (0.8)
(100,000) + (1−0.8)(−20,000) = 76,000

TABLE 3.4 Thompson’s Criterion of Realism

Decision STATE OF NATURE
FAVORABLE UNFAVORABLE CRITERION OF REALISM
MARKET MARKET OR WEIGHTED AVERAGE
ALTERNATIVE ($) ($) (α = 0.8) ($)
Construct a large plant 200,000 −180,000 124,000
Realism
Construct a small plant 100,000 −20,000 76,000
Do nothing 0 0 0
Equally Likely
(Laplace)
• Considers all the payoffs for each alternative
• Find the average payoff for each alternative
• Select the alternative with the highest average

TABLE 3.5 Thompson’s Equally Likely Decision

STATE OF NATURE
FAVORABLE UNFAVORABLE
MARKET MARKET ROW AVERAGE
ALTERNATIVE ($) ($) ($)
Construct a large plant 200,000 −180,000 10,000
Construct a small plant 100,000 −20,000 40,000
Equally likely
Do nothing 0 0 0
Minimax Regret (1 of
4)
• Based on opportunity loss or regret
– The difference between the optimal profit and actual payoff for
a decision
1. Create an opportunity loss table by determining the
opportunity loss from not choosing the best
alternative
2. Calculate opportunity loss by subtracting each payoff
in the
column from the best payoff in the column
3. Find the maximum opportunity loss for each alternative
and pick the alternative with the minimum number
Minimax Regret (2 of
4)
TABLE 3.6 Determining Opportunity Losses for Thompson
Lumber

STATE OF NATURE
FAVORABLE UNFAVORABLE
MARKET MARKET
($) ($)
200,000 − 200,000 0 − (−180,000)
200,000 − 100,000 0 − (−20,000)
200,000 − 0 0−0
Minimax Regret (3 of
4)
TABLE 3.7 Opportunity Loss Table for Thompson Lumber

STATE OF NATURE
FAVORABLE UNFAVORABLE
MARKET MARKET
ALTERNATIVE ($) ($)
Construct a large plant 0 180,000
Construct a small plant 100,000 20,000
Do nothing 200,000 0
Minimax Regret (4 of
4)
TABLE 3.8 Thompson’s Minimax Decision Using
Opportunity Loss

STATE OF NATURE
FAVORABLE UNFAVORABLE MAXIMUM IN
MARKET MARKET A ROW
ALTERNATIVE ($) ($) ($)
Construct a large plant 0 180,000 180,000
Construct a small plant 100,000 20,000 100,000
Minimax
Do nothing 200,000 0 200,000
 TRIAL QUESTION
•
1
 PAY-OFF TABLE: Profit contribution
Gasoline Availability
Investment Shortage Stable Surplus

supply

Hotel -8,000 15,000 20,000

Restaurant 2,000 8,000 6,000

Theatre 6,000 6,000 5,000

Maximax
criterion
Hotel - 20,000
Restaurant - 8,000
Theatre - 6,000

Therefore the maximum of the maxima is 20,000. hence

the best decision is to invest in a HOTEL.
Maximin
criterion
•
 Minimax Regret
Criterion
Gasoline
Regret Availability
Table
INVESTME Shortage Stable Surplus Maximum
NT Supply Regret
Hotel 14,000 0 0 14,000
Restaurant 4,000 7,000 14,000 14,000
theatre 0 9,000 15,000 15,000

Therefore the minimum of the maximum regrets is 14,000

and hence the best alternative investment is either a
HOTEL or a RESTAURANT.
•
 Equally Likely
• (Laplace)
 TRIAL QUESTION
2
Prof. Annan, a corporate raider, has acquired a textile company
and is contemplating the future of one of its major plants, located
in Ahodwo. Three alternative decisions are being considered:
1) Expand the plant and produce lightweight, durable materials
for possible sales to the military, a market with little foreign
competition;
2) Maintain the status quo at the plant, continuing production of
textile goods that are subject to heavy foreign
competition; or
3) Sell the plant now.
If one of the first two alternatives is chosen, the plant will still be
sold at the end of a year. The amount of profit that could be
earned by selling the plant in a year depends on foreign market
conditions, including the status of a trade embargo bill in
Parliament. The following payoff table describes this decision
situation:
 32

State of Nature
Good Foreign Poor Foreign
Decision Competitive Competitive
Conditions Conditions
Expand $800,000
Maintain status quo $1,300,000

Sell now $320,000

 33

(1) Maximax
criterion
Expand - 800,000
Maintain status quo - - 1,300,000
Sell now - 320,000

Therefore the maximum of the maxima is 1,300,000. Hence

the best decision is to Maintain Status Quo.
 34

(2) Maximin
criterion
Expand - 500,000
Maintain status quo - - -150,000
Sell now - 320,000

Therefore the maximum of the minima is 500,000. Hence

the best decision is to Expand.
 35

(3) Minimax Regret

Criterion
Regret Table
State of Nature
Decision Good Poor FCC Maximum
FCC Regret
Expand 500,000 0 500,000
Maintain status quo 0 650,000 650,000
Sell now 980,000 180,000 980,000

Therefore the minimum of the maximum regrets is 500,000

and hence the best decision is to expand.
 36

•
 37

(5) Equally likely

•(Laplace)
Decision Making Under
Risk
 Decision Making Under Risk (1
of 2)
(EMV Approach)
• When there are several possible states of nature and the
probabilities associated with each possible state are
known
• Most popular method – choose the alternative with the
highest Expected Monetary Value (EMV)

EMV  alternative = Xi P 

i 

where
X
Xi = payoff for the alternative in state of nature i
P(Xi) = probability of achieving payoff Xi (i.e., probability of state
of nature i)
∑ = summation symbol
 Decision Making Under Risk (2
of 2)
• Expanding the equation

EMV (alternative i) = (payoff of first state of nature)

×(probability of first state of nature)
+ (payoff of second state of nature)
×(probability of second state of nature)
+ … + (payoff of last state of nature)
×(probability of last state of nature)
EMV for Thompson Lumber (1
of 2)
• Each market outcome has a probability of occurrence of
0.50
• Which alternative would give the highest EMV?

EMV (large plant) = ($200,000)(0.5) + (−$180,000)

(0.5)
= $10,000
EMV (small plant) = ($100,000)(0.5) + (−$20,000)
(0.5)
= $40,000
EMV (do nothing) = ($0)(0.5) + ($0)(0.5)
= $0
EMV for Thompson Lumber (2
of 2)
TABLE 3.9 Decision Table with Probabilities and EMVs for
Thompson Lumber
STATE OF NATURE
FAVORABLE UNFAVORABLE
MARKET MARKET
ALTERNATIVE ($) ($) EMV ($)
Construct a large plant 200,000 −180,000 10,000
Construct a small plant 100,000 −20,000 40,000
Best EMV
Do nothing 0 0 0
Probabilities 0.50 0.50
Expected Value of Perfect Information
(EVPI) (1 of 5)
• EVPI places an upper bound on what you should
pay for additional information
• EVwPI is the long run average return if we have
perfect information before a decision is made
EVwPI = ∑(best payoff in state of nature i)x
(probability of state of nature i)
Expected Value of Perfect Information
(EVPI) (2 of 5)
• Expanded, EVwPI becomes

EVwPI = (best payoff for first state of nature)

× (probability of first state of nature)
+ (best payoff for second state of nature)
× (probability of second state of nature)
+ … + (best payoff for last state of nature)
× (probability of last state of nature)

And

EVPI = EVwPI − Best EMV

Expected Value of Perfect Information
(EVPI) (3 of 5)
• Thompson Lumber Corporation
Example:
• Scientific Marketing, Inc. offers
analysis that will provide certainty
about market conditions (favorable)
• Additional information will cost $65,000
• Should Thompson Lumber purchase the
information?
Expected Value of Perfect
Information (EVPI) (4 of 5)
TABLE 3.10 Decision Table with Perfect Information

STATE OF NATURE
FAVORABLE UNFAVORABLE
MARKET MARKET
ALTERNATIVE ($) ($) EMV ($)
Construct a large plant 200,000 −180,000 10,000
Construct a small plant 100,000 −20,000 40,000
Do nothing 0 0 0
With perfect information 200,000 0 100,000
EVwPI
Probabilities 0.50 0.50
Expected Value of Perfect Information
(EVPI) (5 of 5)
• The maximum EMV without additional information is
$40,000
• Therefore

EVPI = EVwPI − Maximum EMV

= $100,000 − $40,000
= $60,000

So the maximum Thompson should pay for the

additional information is $60,000
 Decision
Trees
• Any problem that can be presented in a decision
table can be graphically represented in a
decision tree
• Most beneficial when a sequence of decisions must be
made
• All decision trees contain decision points/nodes and
state-of-nature points/nodes
• At decision nodes one of several alternatives may be
chosen
• At state-of-nature nodes one state of nature will
occur
Five Steps of Decision Tree
Analysis
1. Define the problem
2. Structure or draw the decision tree
3. Assign probabilities to the states of nature
4. Estimate payoffs for each possible combination
of alternatives and states of nature
5. Solve the problem by computing expected
monetary values (EMVs) for each state of
nature node
Structure of Decision
Trees
• Trees start from left to right
• Trees represent decisions and outcomes in
sequential order
• Squares represent decision nodes
• Circles represent states of nature nodes
• Lines or branches connect the decisions nodes
and the states of nature
 51

EXAMPL
E STATE OF NATURE
Alternative Favourable market Unfavourable
market
(Decision)
P(FM) = 0.5 P(UFM) = 0.5

Construct a large
200,000 -180,000
plant
Construct a small
100,000 - 20,000
plant

Do nothing 0 0

THOMPSON lumber company’s payoff with associated

probabilities. What decision should the organisation take?
 Thompson’s Decision Tree (1
of 2)

FIGURE 3.2 Thompson’s Decision Tree

 Thompson’s Decision Tree (2
of 2)

FIGURE 3.3 Completed and Solved Decision Tree for

Thompson Lumber
Questions???